EARTH, WIND, AND FIRE
New markets are emerging to help Asian companies do their bit for the environment – and earn additional revenues.
By Jason Karaian

For many companies, practicing corporate social responsibility can be a costly exercise with a slim ROI. But that’s not the case for China’s Jinan Iron & Steel Works.

The steelmaker has built a 544-megawatt power plant fueled by waste gases from the steelmaking process, effectively reducing greenhouse gas emissions by some 2.8m tons a year. Jinan registered the project with the United Nations Clean Development Mechanism (CDM), allowing it to package its reduced emissions into CDM credits for sale to companies in Europe. The additional revenues to Jinan: an estimated 100m renminbi (US$13.2m) a year until 2012.

It’s the kind of deal that more of Asia’s CFOs should be considering, especially those in businesses such as power generation, heavy industry, mining, and forestry. The trade in developing-world credits will be worth 4.6 bn euros (US$6.3 bn) this year, double the total two years ago, according to European consultancy Point Carbon. According to the World Bank, 60% of all CDM credits sold in the first three quarters of 2006 came from China, 15% from India, and 9% from other Asian countries.

Specialist firms are descending on Asia to develop projects that cut greenhouse gases and generate emission-reduction credits that companies in Europe can use to offset their obligations under the EU’s carbon dioxide (CO2) cap-and-trade scheme. Jinan’s partner is Noble Carbon Credits UK, a unit of Singapore-listed Noble Group, which claims to be the world’s biggest supplier of CDM carbon credits.

New opportunities are opening up. In February, the Intergovernmental Panel on Climate Change, a group of scientists and government officials gathered by the UN, issued the fourth of a series of much-anticipated reports on global warming. The panel concluded that human activity is exacerbating climate change, leading to more frequent heat waves, heavy precipitation, and severe tropical cyclones. In response, a host of new markets are emerging for financial instruments to help companies offset their emissions, bolster operations against increasingly capricious weather, or simply burnish their green credentials as part of their CSR programs. What follows is CFO Asia’s forecast of the key developments for climate-conscious finance chiefs.

Kyoto flexible mechanisms

The European Union’s mandatory CO2 trading scheme, covering some 6,000 companies in the heaviest polluting industries in its 27 member states, accounts for 60% of the volume, and 80% of the value, of global emissions trading. Most of the remaining trade is in credits generated by the “flexible mechanisms” of the Kyoto Protocol, which are expected to increase in the coming years. This is the market where Noble Carbon sells Jinan’s CDM credits.

Under the European system, a portion of an EU company’s emissions allowance, generally between 10% and 20%, can be covered by UN-certified credits generated by CDM projects that reduce pollution in the developing world. Because achieving emission reductions in countries such as China and India is usually cheaper and easier than in western Europe, companies are expected to maximize their use of developing-world credits in those parts of the world.

Analysts at JPMorgan recently estimated that companies will experience an annual shortfall of 150m to 220m credits between 2008 and 2012, when the Kyoto Protocol ends. (Each credit covers the emission of one ton of CO2.) The analysts reckon that around half of this shortfall can be met by using Kyoto credits. Last year, prices for CDM credits ranged from around 6 euros (US$8) to 17 euros (US$23) per ton, according to Point Carbon.

Noble Carbon, Dublin-based EcoSecurities, and other firms of their kind represent the growing influence of specialist carbon financiers in the CDM market. (Others include AgCert, Camco, Cantor CO2e, and Climate Change Capital.) These speculative investors seek the arbitrage opportunity of generating cheap credits in poor countries to sell to the developed world, primarily Europe, where the benchmark price for domestic CO2 credits in 2008 and beyond currently trades at around 15 euros (US$20). More than 1.2 bn euros (US$1.6 bn) have been raised by private carbon funds to date, according to Sonia Labatt and Rodney White in their book, Carbon Finance.

EcoSecurities has contracted more than 350 CDM projects, employing 18 different emissions-reducing technologies, in 36 countries. This spreads project risks, allowing the company to sell credits forward on a guaranteed basis, says CFO Jack MacDonald. “Buyers don’t have to worry about insurance – that’s our problem.”

Credits from its portfolio have been selling for between 12 euros (US$16) and 17 euros, says MacDonald. Last year, the company sold forward 22m credits, expecting to fetch revenues of 287m euros (US$392m) with a trading margin of 151m euros (US$206m). With that sort of projected profitability, it’s no wonder that the Kyoto credit market is attracting an increasingly broad array of players. “As the market matures, it’s becoming more and more like any other commodity market,” MacDonald notes.

Voluntary carbon offsets

The United States and Australia have not signed the Kyoto Protocol, while Japan, which hosted the environmental summit, only created a limited voluntary emission trading scheme in 2006. But companies covered by the EU’s mandatory CO2 trading scheme aren’t the only ones offsetting their emissions by investing in climate-friendly projects abroad. It’s hard to find a major bank, media company or retailer in Asia and elsewhere that hasn’t pledged in the past few years to go “carbon neutral”, despite a lack of regulations compelling them to do so.

A vibrant, but fragmented, market for voluntary emission-reduction credits is meeting this demand. In the absence of the same regulatory rigor as the mandatory cap-and-trade market in Europe, however, the standards and efficacy of voluntary projects vary widely. The price of voluntary offsets is also much lower than in regulated markets, at around 7.50 euros (US$10.25) per ton of CO2 last year, according to the World Bank.

The size of the voluntary market is also smaller than mandatory schemes, in part because the companies active in the market already emit relatively few greenhouse gases. Still, US-based consultancy ICF International predicts that the global market for voluntary carbon offsets will grow from 10m tons of CO2 in 2005 to 400m tons annually by 2010.

There are several factors driving this bullish forecast, according to Abyd Karmali, ICF’s European managing director. First, with climate change a growing public concern, firms can use offsets to enhance their reputations. “Many companies realize that their carbon footprint isn’t so bad, so going carbon neutral comes at little cost while the upside can be fairly significant,” says Karmali. Second, some industries, such as aviation, expect eventually to be subject to mandatory cap-and-trade schemes, so companies in those sectors are gaining experience by dabbling in voluntary markets. Third, some companies are going green to differentiate themselves from competitors, for instance travel groups that now bundle offsets as part of their holiday packages.

According to Karmali, there are two nascent standards that companies should look for in voluntary offsetting projects. Last year, the World Wildlife Fund modified its Gold Standard methodology for validating CDM projects to suit the voluntary market, while a final version of the Voluntary Carbon Standard, developed by nonprofits, the Climate Group and the International Emissions Trading Association, will be published later this year. More rigorous verification and accreditation will invariably drive up costs, but “given that some of the offsets available are of dubious quality, companies which really value their reputation and brand will naturally migrate towards the higher end of the market,” Karmali predicts.

Another group migrating towards the voluntary offset market is hedge funds, following the lead of Cheyne Capital Management, which launched the first fund focused on voluntary credits in 2005. Last summer, the Bank of New York launched the first centralized registry for voluntary credits, hoping that standardized terms and contracts will drive liquidity and attract a broader range of market participants, as it has for mandatory trading schemes.

Weather-risk markets

While the trade in carbon credit emissions may help mitigate global warming, experts predict that climate change will still make weather systems more volatile. In response, capital markets are spawning innovative financial instruments to hedge these risks, targeting not only companies in the West but also those in Asia, which is experiencing longer periods of drought and more frequent typhoons.

Last year, the number of trades on the Chicago Mercantile Exchange (CME), where most weather-risk products are traded, increased by a factor of four, while their value rose by a factor of eight (see chart, this page). Several new products have been launched recently that track phenomena beyond traditional temperature-based instruments, spurred by the increasing unpredictability and severity of storms.

In 2006, risks of typhoons and earthquakes in Australia, earthquakes in Mexico, and tornadoes and hail in the United States were securitized for the first time. Last month, reinsurer Carvill opened trading in derivatives tied to the size and wind velocity of hurricanes off the US Atlantic coast.

“The CME is doing a good job of handling basic, bulk weather,” says Steve Smith, senior vice president at ReAdvisory, Carvill’s analytical arm. “With the hurricane index, we’re adding in the extreme, shock weather. With instant pricing and fast settlement, it has all of the things you expect from a mature financial product, providing a broader appeal beyond just the insurance industry.”

Another trend in weather-risk markets, according to Barney Brown, a consultant with financial market firm Detica, is the growing use of hybrid instruments that package together multiple weather factors. In November, for example, ABN Amro and underwriter Catlin sold tranches of a collateralized debt obligation-style security that covers nine different catastrophic risks – earthquakes, hurricanes, and windstorms in Europe, Japan, and the United States. “The only thing that’s missing is thunder and lightning, but I’m not quite sure how you can trade that,” says Brown.

Insurance issues

To date, no insurer offers explicit coverage for climate change. The potential damages associated with it, however, are influencing all varieties of corporate policies, boosting premiums for weather-related risks, expanding exclusions for losses associated with climate change and increasing deductibles for weather-related losses.

In these times of heightened sensitivity to an increasingly unstable climate, companies should tell their brokers about all or any improvements, however small, to their properties, says Tom Roche, engineering manager at insurer FM Global. In fact, it’s often the seemingly small measures that make a big difference in protecting a building from storm damage. “We talk with clients about putting an extra line of bricks around a property, or building a plant a little bit higher,” Roche says. “From a financial point of view, these things are quite simple.”

Environmental concerns also factor in to insurance contracts in less obvious ways, according to Warren Diogo, a climate-change specialist for risk consultancy Marsh. Companies covered by the EU’s emissions-trading scheme, for example, could expand business interruption insurance to take account of CO2 allowances on their balance sheets. So if a power company loses the use of a gas-fired plant, requiring it to ramp up a more carbon-intensive coal plant, the unforeseen additional CO2 allowances needed to offset the event could be covered by insurance, he says.

Finally, although climate change is often thought of as a vague, looming threat, it has the potential to affect corporate directors in a personal way. Investors have filed 47 resolutions related to climate change at US-listed companies so far this proxy season, according to shareholder watchdog ISS. Institutional investors are also agitating for greater disclosure of climate-related risks. In February, the Carbon Disclosure Project, a group of nearly 300 investment groups managing 30 trn euros (US$41 trn) of assets, sent questionnaires to the 2,400 largest listed companies in the world. Insurers will be scrutinizing responses to evaluate D&O exposure, says Diogo. “There is definitely the potential for liability against directors and officers for a lack of – or ineffective – action on climate change.”

Inevitably, US courts are now dealing with the first batch of lawsuits against companies accused of contributing to climate change. “Some lawyers say it’s legally impossible to make the connection between global warming and corporate liability,” notes Dan Anderson, a professor of risk management and insurance at the University of Wisconsin. He heard the same sort of arguments, he adds ominously, in the early stages of asbestos litigation.

Jason Karaian is senior editor for CFO Europe. Additional reporting by John Goff and Yang Jian.